Even though Sean P. McAlary lost in Tax Court, the decision in his case shows that S Corporations are still a valid self-employment tax avoidance strategy. If you operate as a sole-proprietorship, all of its income will be subject to self-employment tax. If you put the business into an S Corporation, none of the income will be subject to self-employment tax. Entrepreneurs will be inclined to heavily discount any decrease in future social security benefits as a trade-off, so organizing as an S Corporation and avoiding self-employment tax seems like a no-brainer for a sole proprietor.

The Exposure

There is a catch. In the C corporation arena, the IRS is wont to argue that very high salaries are disguised dividends. With S Corporations, the Service may take the position that corporate distributions are actually disguised salary. That can be pretty ugly, since the penalties for being late with payroll taxes are fairly stiff. When Sean McAlary Ltd got hit for just over $10,000 in FICA and Medicare tax, that did not really prove that the S Corporation low or no payroll strategy is a bad idea. I mean, nothing ventured, nothing gained. What is nasty is the $6,000 or so in penalties.

Win, Loss or Draw ?

So would Mr. McAlary have been better off for 2006 if he had run his business as a proprietorship and paid self-employment tax on the entire profit. Forgive me for not doing the precise computation, but it is actually close to a push. Mr. McAlary had his corporation pay him no salary at all. There was an agreement in place for his salary to be $24,000. The IRS expert argued that his salary should have been $100,755. The Tax Court determined that $83,200 was actually the right number. According to the discussion in the case the net income of the S Corporation was $231,454 and the total on page 2 of his Schedule E was $200,877. His distributions from the S corporation were $240,000. I can’t tell why there is a difference. Perhaps he or his wife has another S Corporation that lost money. Regardless, by running as an S Corporation, he avoided the effect of Self-employment tax on between roughly $120,000 and $150,000 of income, even after getting audited.

That nasty $6,000 in penalties probably puts him a bit behind particularly when you throw in thetsoris of going all the way to Tax Court. Mr. McAlary represented himself, though, and did win a small concession, so you can’t rule out that he may have enjoyed the fight. When you consider other years, where he did not get audited, he came out way ahead using the strategy.

How To Win Almost For Sure ?

Explaining things like this throws me back to the early days of my career. My elaborate analysis would need to be translated into terms that the client would understand. After absorbing as much of the analysis as he thought relevant, Herb Cohan would then say to the client – “Don’t be chazzer !” The more elaborate version of that caution on the limits of aggressiveness in tax planning was “Pigs get fed. Hogs get slaughtered.”.

What the McAlary case teaches us is not that you can’t use an S Corporation to avoid SE/payroll taxes. It teaches us that you really should not use the strategy to avoid SE/payroll taxes entirely.